CHAPTER ONE

INTRODUCTION TO

G CO O CSMANAGERIAL ECONOMICS

Dr. Mohammed Alwosabi 1

Economics and Managerial Decision Making• Managerial economics is one of the mostManagerial economics is one of the most

important and useful courses.

• From its name, managerial economics is a bi ti f t d i dcombination of two words: economics and

management.

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• Economicsis the study of how best people,is the study of how best people, governments, firms, and societies make their choices to allocate their scarcetheir choices to allocate their scarce resources among competing uses of production, distribution, and consumptionproduction, distribution, and consumption of goods and services.

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• Managementis the discipline of organizing and allocatingis the discipline of organizing and allocating firm's scarce resources to achieve its desired objectives.desired objectives. It involves the ability to organize and administer various tasks in pursuit ofadminister various tasks in pursuit of certain objectives.

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• We can combine these two terms and define managerial economicsg

• Managerial economics (ME) is the study of how managers can applyis the study of how managers can apply economic principles and analyses as well as quantitative tools and methods in making anquantitative tools and methods in making an effective (optimal) business and managerial decisions involving the best use (allocation)decisions involving the best use (allocation) of the organizations' scarce resources to achieve their objectivesachieve their objectives.

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Why Managerial Economics?1.To provide students with a basic1.To provide students with a basic

understanding of the economic theory and analytical tools that can be applied in realanalytical tools that can be applied in real life decision making problems facing the managers of private, public, and not-for-managers of private, public, and not forprofit organizations.

2 To show students how to combine the2.To show students how to combine the scarce economic resources of a business so that these resources are allocated in theso that these resources are allocated in the most efficient manner that maximizes the value of their enterprisevalue of their enterprise.

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Important Questions in Managerial Decision Making Process g• In making key business decisions,

managers must answer the followingmanagers must answer the following questions:

First: What are the microeconomic conditionsFirst: What are the microeconomic conditions in a particular market?

Th ti i ht i l dThese questions might include: 1.Market Structure (number of firms competing with one another), 2.Market Supply and Demand Conditions pp y(elastic or inelastic, how to increase demand),

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3. How consumer behavior affects revenues4. How the available technology affects4. How the available technology affects

production, 5 How input prices affect costs5. How input prices affect costs, 6. Government Regulations, 7. International Dimensions, 8. Future Conditions, ,9. Whether entry into the market is easy or

difficult,difficult, 10.Amount of information available to market

participantsparticipants8

Second: What are the macroeconomic factors? 1.Gross Domestic Product (GDP)2 Factors affecting macro spending behavior2.Factors affecting macro spending behavior3.Changes in consumption and investment b h i f i t i di id lbehavior of private individuals4.New directions of a country’s monetary and/or fiscal policies5.Developments occurring internationally that p g yaffect domestic economy

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• Changes in the macro environment affect individual firms and industries through the gmicroeconomic factors of demand, production, cost, and profitability.p , , p y

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3. Should our firm be in this business? • The answer to this question is based onThe answer to this question is based on

the previous two questions4 If so what price and output levels achieve4. If so, what price and output levels achieve

our goals (of maximizing profits or minimizing costs?)minimizing costs?)

• This requires a careful analysis of the t k t t t d d dcurrent market structure and demand

components and sensitivity as well as the fi ’ d ti itfirm’s production capacity

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5. How can we maintain a competitive advantage over our competitors? (by g p ( yorganizing and investing in the organization's resources)g )

a. Cost-leader? A business strategy where a firm becomes the low cost producer in thefirm becomes the low cost producer in the industry

b Product Differentiation? whether productsb. Product Differentiation? whether products sold are differentiated or undifferentiated

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c. Market Niche? A targetable subgroup within a market segment distinguishable g gfrom the rest of the market by certain characteristics

d. Outsourcing, alliances, mergers, acquisitionsacquisitions

e. International Dimensions? Suppliers, Customers CompetitorsCustomers, Competitors

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6. What are the risks involved? • RiskRisk

can be defined as the chance or possibility that outcomes of an action will turn out tothat outcomes of an action will turn out to be worse than expected

• Risk and uncertainty are often used interchangeably.

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• Difference between Risk and UncertaintyWhere future events can be defined andWhere future events can be defined and probabilities assigned, we have a case of risk.risk.

• If there is no way to assign any probabilities to future random events weprobabilities to future random events, we are addressing pure uncertainty. E th h thi di ti ti i• Even though this distinction is theoretically important, many writers omit it tt f iit as a matter of convenience.

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• There are many types of risk that business face such as:

1. Changes in demand and supply conditions2. Technological changes and the effect of g g

competition3. Changes in interest rates and inflation rateg4. Exchange rates for companies engaged in

international trade5. Political risk for companies with foreign

operationsp

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Steps for Managerial Decision Making: 1. Defining the goals of the organizationg g g2. Identifying problems and opportunities3. Analyzing alternatives from which choices3. Analyzing alternatives from which choices

can be made (Choosing alternatives always have costs and benefits)y )

4. Making choices that are best from the standpoint of the firm or organization p g(Optimal choice)

5. Comparing actual and targeted p g gperformance, and defining any problems.

6. Implementation and monitoring the p gremedial actions.

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The Economics of a Business• The economics of a business refers to theThe economics of a business refers to the

key factors that affect the ability of a firm to earn an acceptable rate of return on itsto earn an acceptable rate of return on its owners’ investment.

• The most important of these factors• The most important of these factors (microeconomic conditions) are

1 C titi h th k t i t1. Competition: how the market environment influences their ability to set prices and

d t titresponds to competitors2. technology: how production technology

and input prices affect costs18

3. Customers: how consumer behavior affects revenue

• The economics of a business will be understood through the study of "four-understood through the study of fourstage model" of change

• The "four stage model" shows how• The four-stage model shows how managerial economics is concerned on whether or not a potential market iswhether or not a potential market is penetrable and profitable to the firm.Th "f t d l" i f k f• The "four-stage model" is a frame work of change that shows how changing

i diti ff t lleconomic conditions affect well-established firms. 19

Stage I: Cost Plus• “The good old days”.The good old days . • This refers to the ability of a well-

established firm to dominate the market andestablished firm to dominate the market and control the price (kind of monopoly). It k it t t hi hi h fit• It marks up its costs to achieve high profit margins (cost-plus pricing).

• However, changes in technology, competition and customers put downward pressure on a company's profit margins and market share and force firms into stage II.

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Stage II: Crisis and Cost Management• The company seeks refuge in costThe company seeks refuge in cost

management through cost cutting, downsizing, restructuring, anddownsizing, restructuring, and reengineering in response to these changes.

• But continual focus on cost had its limits in• But continual focus on cost had its limits in the ability of increasing profits.M k t hi hl titi i thi t• Markets are highly competitive in this stage

• The firm is most likely to contemplate the nature of its production methods and cost behavior and assess the current level of competition which lead the firm to go to stage III. 21

Stage III: Reform and Revenue Management• Because of the limits to the growth inBecause of the limits to the growth in

profits, company tries to shift its focus from cost management to revenue management.cost management to revenue management.

• Firms in stage III focus on narrowing product lines to those offering the greatestproduct lines to those offering the greatest revenue potential. Th f i "t li th" ( hi h• The focus is on "top-line growth" (which means the increase in gross sales or

)revenues).

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• Although the company may have reaffirmed its ability to grow its top line, there is a y g p ,question about its ability to grow in a profitable manner. p

• Thus, stage IV becomes a necessary part of a company's full recovery from the impacta company s full recovery from the impact of changing economics.

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Stage IV: Recovery and Revenue Plus• Company strives for profitable growth p y p g

(revenue-plus).• The firm in this stage will continue to g

increase its revenue but with more focus on profit.

• It is a necessary part of the company's full recovery from changing economics.

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APPENDIX 1Review of Economic TermsReview of Economic Terms

• Microeconomics Vs. MacroeconomicsS it d O t it C t• Scarcity and Opportunity Cost

– Economic Goods Vs. Free Goods – marginal or incremental approach – optimizationoptimization – Allocation decision R (F t f P d ti )• Resources (Factors of Production)

• Society: What, How, and For Whom• Firm: What, How, and For Whom

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• Allocation decisions must be made because of scarcity. Three choices:y

• What should be produced?• How should it be produced?• How should it be produced?• For whom should be produced?• Economic decisions of the firmWhat - begin or stop providing g p p g

goods/services (production)How - hiring staffing capital budgetingHow - hiring, staffing, capital budgeting

(resourcing)For whom – target the customers most

likely to purchase (marketing) 26

• Although firms mainly are market oriented we can apply the command and traditional pp yprocess to them.

• There are essentially five ways a countryThere are essentially five ways a country can answer these questions:

1 Market Mechanism1. Market Mechanism2. Command Mechanism3. Mixed Mechanism4. Islamic Mechanism5. Traditional Mechanism

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Economic Models

Entrepreneurs versus Managers

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